[Federal Register Volume 68, Number 86 (Monday, May 5, 2003)]
[Proposed Rules]
[Pages 23632-23634]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-11047]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-100420-03]
RIN 1545-BB90


Safe Harbor for Satisfying Statutory Requirements for Valuation 
under Section 475 for Certain Securities and Commodities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Advance notice of proposed rulemaking.

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SUMMARY: This document describes and explains a possible framework for 
a safe harbor (including recordkeeping and record retention 
requirements) that would satisfy the statutory requirement to value 
certain securities and commodities under section 475 of the Internal 
Revenue Code. This document also invites comments from the public on 
this safe harbor and other alternative valuation methodologies. All 
materials submitted will be available for public inspection and 
copying.

DATES: Written or electronic comments must be submitted by August 4, 
2003.

ADDRESSES: Send submissions to: CC:PA:RU (REG-100420-03), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered Monday through Friday 
between the hours of 8 a.m. and 4 p.m. to: CC:PA:RU (REG-100420-03), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW., 
Washington, DC. Alternatively, taxpayers may send electronic comments 
directly to the IRS Internet site at http://www.irs.gov/regs.

FOR FURTHER INFORMATION CONTACT: Concerning submissions, LaNita Van 
Dyke, (202) 622-7180; concerning the proposals, Marsha Sabin or John W. 
Rogers III (202) 622-3950 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

A. Overview

    Section 475(a) requires dealers in securities to mark their 
securities to market. If a security is inventory, it must be included 
in inventory at its fair market value. If a security is not inventory 
and is held at the end of the taxable year, it must be treated as if it 
were sold for its fair market value on the last business day of the 
taxable year. Mark-to-market treatment is available on an elective 
basis to commodities dealers and to traders in securities or 
commodities. See sections 475(e) and (f).
    Although the meaning of the term ``fair market value'' has long 
been established, it has been difficult for both taxpayers and the IRS 
to determine fair market value in certain situations. To reduce the 
administrative burden on

[[Page 23633]]

taxpayers and the IRS of determining fair market value under section 
475, the IRS and the Treasury Department are considering the 
publication of a notice of proposed rulemaking that, by allowing values 
used on a financial statement to be used on the tax return, would 
provide an elective safe harbor for satisfying the statutory 
requirement to value securities and commodities.
    Three broad principles guide eligibility for the safe harbor. 
First, any mark-to-market methodology used on a financial statement 
submitted for financial reporting purposes would have to be 
sufficiently consistent with the mark-to-market methodology used under 
section 475. Second, the financial statement would have to be one for 
which the taxpayer has a strong incentive to report values fairly. 
Third, if requested, the taxpayer would have to timely provide the IRS 
with the information and documents necessary to verify the relationship 
between the values reported on the financial statement and the values 
used for purposes of section 475.

B. Principle One: Mark-to-Market Methodology for Financial Reporting

    To qualify for the safe harbor, a mark-to-market methodology used 
for financial reporting should be sufficiently consistent with the 
requirements of a mark-to-market methodology used for section 475. 
Under section 475, a mark-to-market methodology must (i) value 
securities and commodities as of the last business day of each taxable 
year, (ii) recognize into income the gains and losses arising from 
changes in value each year, and (iii) compute gain or loss on 
disposition by reference to the value at the end of the prior year. To 
the extent that mark-to-market methodologies for financial reporting 
and section 475 differ, the IRS and the Treasury Department request 
comments identifying the differences and addressing whether and how the 
differences should affect the safe harbor.
    The valuation standard under section 475 is fair market value, the 
price at which property would change hands between a willing buyer and 
willing seller, neither being under any compulsion to buy or sell and 
both having reasonable knowledge of relevant facts. The IRS and the 
Treasury Department are considering whether to use the fair value 
standard under U.S. Generally Accepted Accounting Principles (``GAAP'') 
as a proxy for the fair market value standard required for tax 
purposes. In particular, the IRS and the Treasury Department seek 
comments on whether GAAP permits (i) valuation of securities at the bid 
price, (ii) downward adjustments from mid-market values for future 
administrative, hedging, or financing expenses, or (iii) one or more 
redundant downward adjustments from mid-market values for credit risk. 
(In other words, if future cash flows are discounted to present value 
using a rate, such as LIBOR (London Interbank Offered Rate), that 
corresponds to the credit quality of the counterparty, is there a need 
for any additional credit adjustment?)
    The IRS and the Treasury Department are interested in receiving 
information on the types of adjustments that are currently used for 
financial statement purposes and an explanation of these adjustments. 
Comments are requested on the Financial Accounting Standards Board's 
consideration of fair value reporting of derivatives and the valuation 
of projected cash flows and any impact that has on how taxpayers are 
reporting any valuation adjustments for fair value purposes.

C. Principle Two: Financial Statements and Business Use

    Two factors are relevant in establishing that the taxpayer has a 
strong incentive to report values of the securities and commodities 
fairly on the financial statement: (i) reporting of values on a 
financial statement; and (ii) significant use of those reported values 
in the taxpayer's business.
    As to the reporting of values, the IRS and the Treasury Department 
are considering various types of financial statements for the safe 
harbor. Three classes of financial statements under consideration are:
    (1) A financial statement required to be filed with the Securities 
and Exchange Commission (``SEC'') (the 10-K or the Annual Statement to 
Shareholders);
    (2) A financial statement required to be provided to the Federal 
government or any of its agencies (other than the SEC or the IRS); and
    (3) A certified audited financial statement not required to be 
filed with the SEC or another Federal agency.
    In certain limited circumstances, it may also be appropriate to 
consider financial statements required to be filed with a state 
government or any of its agencies, a political subdivision of a state, 
or possibly a foreign regulator.
    It may also be relevant whether a statement is provided to equity 
holders or creditors.
    Comments are requested on the extent to which each of these various 
classes of financial statements is appropriate for the safe harbor and 
whether any other classes of financial statements may be as well.
    As to significant use of reported values in the taxpayer's 
business, potentially significant uses include guiding the taxpayer's 
pricing and risk management decisions and determining employee 
compensation.
    Special considerations arise if securities or commodities are held 
by a party related to the issuer or if derivatives in securities or 
commodities (including forward contracts in cash markets) exist between 
related parties. Financial consolidation can cause these securities or 
commodities (including derivatives) to be either eliminated (because of 
netting) or incompletely reported on financial statements. 
Additionally, in certain circumstances, these related party 
transactions may not receive the same level of regulatory scrutiny. It 
is not clear, therefore, whether the safe harbor would be appropriate 
for securities or commodities held by a party related to the issuer or 
for derivatives in securities or commodities that exist between related 
parties.

D. Principle Three: Recordkeeping and Record Production

    Under the safe harbor, examinations of returns would focus on how 
the values used in the financial statements relate to gain and loss on 
the tax returns. Consequently, records would have to clearly show: (1) 
That the same value used on the financial statement was used on the tax 
return; (2) that no security subject to section 475 and reported under 
the required methodology on the financial statement was excluded in the 
application of the safe harbor; and (3) that only securities or 
commodities subject to section 475 had been carried over to the tax 
return under the safe harbor.
    Given the complexity of the business operations of many taxpayers, 
comparing a single line on the financial statement to a single line on 
the tax return will not suffice to verify that the same value used for 
the financial statement was used on the tax return. Therefore, a safe 
harbor will impose specific verification and reconciliation 
requirements.
    The IRS and the Treasury Department are concerned about valuation 
issues that may arise from pooling of securities and commodities. 
Comments are requested on how securities and commodities are pooled for 
purposes of financial reporting, how they are pooled for tax reporting, 
and how the Commissioner can verify the basis determination of a single 
position contained in the pool if that position is sold or settled in 
the year following the

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mark and other positions in the pool are not sold.
    The IRS and the Treasury Department are similarly concerned about 
the consolidation and de-consolidation of the business structure. 
Comments are requested on the impact of the consolidation and de-
consolidation on determining whether the same securities and 
commodities will be reflected on both the financial statement and the 
tax return.
    The IRS and the Treasury Department are considering rules that 
would require electing taxpayers to maintain and, if requested, provide 
to the Commissioner in a timely manner the following records: (1) Books 
and records clearly establishing that the values used in determining 
gain or loss under section 475(a) for eligible securities or 
commodities were the values used in the financial statement; (2) for 
taxpayers filing a Form 1120, a reconciliation of the amount of net 
income reported on the financial statement to the amount reported on 
line 1 of the Schedule M-1 on the Form 1120, Corporate Income Tax 
Return; and (3) for other taxpayers, a similar reconciliation schedule. 
The documents for reconciliation purposes include supporting schedules, 
exhibits, computer programs used in producing the values and schedules, 
and documentation of rules and procedures governing determination of 
the values. Books and records would include all those that are required 
to be maintained for financial or regulatory reporting purposes, even 
if those books and records are not specifically covered by section 
6001. Comments are requested on whether less burdensome recordkeeping 
requirements could be developed that would still allow for effective 
verification of conformity.
    The IRS and the Treasury Department are considering situations in 
which the Commissioner should enter into agreements with specific 
taxpayers establishing which records would have to be maintained, how 
the records would have to be maintained, and how long the records would 
have to be retained. Because an agreement would be tailored to a 
particular taxpayer's operations and environment, it is expected that 
an agreement would arise only after individual negotiations. Although 
no taxpayer would be entitled to an agreement, an agreement based on an 
early understanding of a taxpayer's operations would be in the best 
interests of tax administration and, therefore, would be encouraged.

E. Eligible Taxpayers

    The safe harbor is being considered for dealers in securities under 
section 475(c)(1). Whether the safe harbor would also be extended to 
securities traders, dealers in commodities, and commodities traders 
would largely depend on whether the extension would comport with the 
principles described in the Overview.

F. Eligible Securities and Commodities

    Section 475 applies to a wide variety of securities and 
commodities. It is relatively easy for both taxpayers and the IRS to 
determine the fair market value of positions for which pricing 
information is readily available, such as most actively traded personal 
property. The need for a safe harbor is most pressing for positions for 
which pricing information is not readily available, including more 
complex notional principal contracts and derivative instruments, and 
hedges described in sections 475(c)(2)(D), (E), and (F). Comments are 
requested on what securities should be included in the safe harbor.
    Commodities raise problems similar to those for securities, so the 
need for a safe harbor is similarly pressing for commodities (including 
commodities derivatives) for which pricing information is not readily 
available. Comments are requested addressing application of a safe 
harbor for commodities.

G. Comments on Other Valuation Methodologies and Safe Harbors

    Comments are requested on whether there are other methodologies for 
determining fair market values under section 475. Comments are also 
requested on whether other safe harbors could act as proxies for fair 
market value under section 475.

Lon B. Smith,
Associate Chief Counsel (Financial Institutions and Products).
[FR Doc. 03-11047 Filed 5-2-03; 8:45 am]
BILLING CODE 4830-01-P